Banks and Asset Write Offs

Banks are using this time to take substantial write offs against their assets. The time is right for them to do this and the investment community expects them to. It would be imprudent for any institution to NOT take substantial write offs now. But, I am only arguing that the write offs should be realistic.

It should not be the case that managements try and ‘over shoot’ their losses so as to show favorable results in the future. The managements of financial institutions must work to regain the trust of their customers and investors and this can only be achieved if the managements show that they understand and can control their balance sheets. To me, it is just another sign of bad management to try and manipulate earnings now so that these institutions can re-coop these faux-values in the future. How dumb do they think we are?

Yesterday, Citigroup, Inc. reported its fourth RED quarter, writing down another $4.4 billion in assets. This brings their total writedowns to about $45 billion! Merrill Lynch & Co. wrote down $9.5 billion bringing its total writedowns to over $50 billion! The day before J. P. Morgan Chase & Co. reported write downs of $3.6 billion as well as a $640 million after-tax loss related to its acquisition of Washington Mutual. Wells Fargo set aside $2.5 billion for future loan losses and the Bank of New York Mellon Corp. increased its credit loss provisions by 20%.

This is the time in the financial cycle when organizations must come up with a firm estimate of the asset base they have to work with. They must reduce their reliance on financial leverage as much as they prudently can. They must reduce their interest rate risk by immunizing their balance sheets as much as possible. They must reduce their reliance on accounting ‘gimmicks’. They must improve their reporting and communicating processes so as to achieve as much openness and transparency with their customers and investors as they can.

To me, these are nothing more than good management practices (See my post of October 14, “Good Management Never Goes Out of Style.”). They tend to go out of use as an economy heats up and are forgotten the most right before a financial system starts to contract. Thus, management must take time and effort to get their act back in order once the contraction begins. Businesses NEVER just “tend to business” during these times because they must focus on getting back to basics and this can almost totally distract a management during this period.

Furthermore, in my estimation, financial institutions have another task at this time. To me their business model has to change somewhat to reflect the advance of Information Technology and the uses of information and data that have resulted from these advancements (See my post of October 16, “The Special Case of Financial Institution.”). It is going to be interesting to see how banks and other financial institutions adjust to these changes and create workable models of sustainable competitive advantage without just relying on financial engineering to generate earnings. Trading models and arbitrage models are unstable in the longer run and cannot help build institutions that are going to excel and last.

The financial industry is going to be a very interesting one to watch in the next few years and there are going to be some real opportunities in which to invest. It may be a little early to “pick a horse” right now…although we seem to be coming through the financial collapse we still have the economic contraction to go through and this will cause other strains and stresses on our banking and financial system. And, it seems as if most analysts are predicting that this adjustment will be relatively long and deep.

There will arise some financial organizations that will really be good buys. The question will be about how to pick them. I have expressed some ideas over this past week and I will just repeat what I think is going to be the most important factors to concentrate on. First, don’t just look at the person at the top. J. P. Morgan’s Jamie Dimon and Citi’s Vikram Pandit are getting a lot of the press right now. They, and a couple of other chief executives, are ‘showing well.’ The important thing to me, however, is the quality of the teams the chief executives are building around them. This may be difficult to discern, but a ‘good’ top executive is one who is proud of his or her team and allows them to be known and to shine. Stay away from the chief executive (and his or her company) which is the only one allowed to be in the spotlight.

Second, check out where the organization is going. The idea of focus is crucial here. Is the organization doing a good job of defining its business and the fundamentals that underlay this business? As mentioned, organizations get in trouble when they cannot define their businesses well and rely on financial engineering or ‘gimmicks’ to produce results. This is going to be somewhat tricky as financial institutions ‘re-tool’ their business model to fit modern information technology and the new regulations and regulatory institutions that will inhabit the environment. Look less to trading and arbitrage to carry the day and more to the development of products and services that build on the evolving technology and establish customer relationships.

Finally, observe how the management team brings innovation to the marketplace. Financial institutions are dealing more and more with Information Goods and consequently must learn how to adapt and innovate within a constantly changing world. In order to do this well, managements must learn from the Information Technology industry. The managements of financial institutions must realize, however, that information is inexpensive, tends to be ubiquitous, and cannot be controlled. How these managements handle this reality is ultimately going to determine who the winners are in the future.